The Capital
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The Capital

Security Or Commodity? Regulatory Clarity In Cryptocurrency

By the time of this posting, you may have already heard or read about the SEC lawsuit filed against Ripple (announced December 22, 2020). This was a developing story, as the fintech company Ripple is under a SEC lawsuit regarding the sale of their XRP token as an unregistered security. As a result, the price of XRP has taken a huge tumble in the market. That came just weeks after XRP surged and the Spark token airdrop snapshot. It couldn’t have come at a worse time, but why would the SEC decide on filing the lawsuit now when they could have done so in the past?

If you are deep in the crypto space, you will probably come to the point where you may want to understand whether cryptocurrency is considered a security or commodity. Non-financial noobs may not even understand it clearly, which is why the Ripple lawsuit may not make sense. The reason the SEC has come after Ripple has to do with the $1.3 billion sales of XRP as an unregistered security. The lawsuit also charges Ripple’s top two executives. Ripple does not consider their token or coin a security, but currency like money. So, who is right, or is this just one of those regulatory clarity issues that fall under a gray area?

The Definition Of A Security

Securities can be defined as fungible and tradable financial instruments used to raise capital in public and private markets. They can be equity, debt, or a combination of both equity and debt. Public sales of securities require regulation from the SEC in the United States. All securities must be filed and registered with the SEC in order to meet compliance with financial regulators.

To put some history into context, the definition of a security was established by the US Supreme Court in 1946. It came about during the SEC vs. Howey court case. In the judgment of the case, the court came to a decision that a security is based on 4 criteria:

  1. The existence of an investment contract
  2. The formation of a common enterprise
  3. A promise of profits by the issuer
  4. Use of a third party to promote the offering

This criteria has become known as the Howey Test. The courts came to a determination that:

“the transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land…they are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise.”

This law may be outdated when it comes to decisions regarding cryptocurrency, but is applicable at the moment. According to what the SEC has filed, Ripple has passed the Howey Test. In that case, many cryptocurrency distributed during their early ICO (Initial Coin Offering) may also pass the Howey Test. Some projects, like EOS, have settled their case with the SEC. The company behind EOS, block.one, settled with the SEC for charges of selling an unregistered digital asset during their ICO. They paid $24M during the settlement.

Other cryptocurrency, like Bitcoin (BTC) and Ethereum (ETH) have been classified as commodities and therefore do not pass the Howey Test. As a commodity, the two digital assets can be considered as currency. Then SEC chair Jay Clayton classified BTC as a store of value commodity. The SEC chair explained:

“We determined that bitcoin was not a security, it was much more payment mechanism and store of value.”

Likewise, ETH is also not considered a security. At one point in time, it may have been during its ICO stage. It may be past the statutes of limitations that can be considered so technically at this point in time ETH is not a security. According to SEC Director of Finance Bill Himan:

“Based on my understanding of the present state of ether, the ethereum network, its decentralized structure, we believe current offers and sales of ether are not securities transactions”

Both the Bitcoin and Ethereum blockchain are decentralized to some degree and they are not issued by a company. They have no central organization to speak of, no CEO or administrator that controls the supply. All the protocols are programmed in code and not manipulated by a group or entity. XRP, on the other hand, is issued by an entity or body i.e. Ripple.

The XRP Issue

The US SEC would classify Ripple’s XRP as a security based on the definition. This is because XRP is a digital asset that promises future capital gains to its holders, or in this case, what the SEC would consider as investors. From Ripple’s viewpoint, they are not selling a security. Holders of XRP are not considered stockholders in Ripple the company. An XRP holder does not have equity with Ripple. Holders also don’t hold an investment contract, other than the token through their digital wallet. Holders do not have to sign any document that claims their ownership, it is all recorded on Ripple’s ledger. Could that be even considered a contract? We have to look at what the critics also say about Ripple and XRP.

One of the claims to XRP being a security is that it is being promoted by a private company, which could be considered a third party according to the Howey Test. They promise future profits, and it is under a common enterprise in Ripple, the company. It is also highly centralized since most of the XRP tokens are under Ripple’s control and which they also sell. Other allegations include the failure to offer and register the sales of XRP in accordance with the law. According to the SEC filing:

“The SEC’s complaint, filed today in federal district court in Manhattan, charges defendants with violating the registration provisions of the Securities Act of 1933, and seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.”

Ripple has not been accused of fraud (at the moment), but only for violating the rules regarding security offerings.

In Ripple’s defense, many holders of the token have petitioned (December 29, 2020) to have XRP declared a virtual currency. About 24,000 investors in Ripple have requested a halt to the SEC lawsuit as well. XRP holders have a right to express their disagreement with the SEC as many have invested heavily in the digital asset.

Some digital exchanges are either halting XRP trades like Coinbase or plan on delisting it like Binance. The reason the digital exchanges are doing this is in order to meet SEC compliance because they could be found in violation of selling an unregistered security. That would be more trouble for them.

What To Expect

We can expect regulatory clarity whichever way this is settled. It is not a good sign for the crypto space if Ripple loses their case. It can have a ‘ripple effect’ which could affect other cryptocurrencies that may be deemed as securities. It all depends on how decentralized a project’s blockchain system is and how much they control the token supply. This could be a wake-up call to more centralized blockchains to start decentralizing their network and develop their protocol to treat their token as more of a commodity. Perhaps the SEC has a strong case against Ripple this time around compared to the past.

XRP was supposed to be the bridge between cryptocurrency and traditional financial institutions. It provides its ODL (On-Demand Liquidity) for frictionless settlement of cross border payments like money remittances. It cuts the settlement time to seconds and also offers a lower-cost solution to other money messaging and remittance networks. Ripple has presented their company as willing to work with banks and other financial institutions to meet compliance with the law. They have been building up partnerships with many institutions over the years, so the SEC filing may come as a surprise to token holders of XRP.

Whatever the decision is, if you are not Bitcoin or Ethereum, and the SEC never mentioned that you are not a security, your digital asset might be a security. If their network is decentralized enough without any form of entity controlling the supply of tokens, it may be on the safe side. Once this case is decided, maybe the SEC may finally give a ruling for all cryptocurrency to comply with regarding digital assets in the US. Since the US is influential in global finance, this ruling could have an effect not just on Ripple but other projects that are similar to XRP. The ruling could be the regulatory clarity coming to the crypto space.

(First published in The Capital — January 5, 2021)

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Vincent Tabora

Vincent Tabora

Editor HD-PRO, DevOps Trusterras (Cybersecurity, Blockchain, Software Development, Engineering, Photography, Technology)

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